Do Tournaments Solve the Adverse Selection Problem?

Forthcoming in the Journal of Economics and Management Strategy

32 Pages Posted: 23 Jan 2017  

Theofanis Tsoulouhas

University of California-Merced, School of Social Sciences, Humanities & Arts, The Ernest & Julio Gallo Management Program

Multiple version iconThere are 2 versions of this paper

Date Written: December 22, 2016

Abstract

This paper provides a solution to a puzzle in the analysis of tournaments, that of why there is no agent discrimination or differential contracting in certain business practice settings. The paper examines the problem of a principal contracting with multiple agents whose activities are subject to common shocks. The presence of common shocks invites the use of relative performance evaluation to minimize the costs of moral hazard. But, in the additional presence of adverse selection, the analysis shows that there may be no need for ex ante screening through menus of offers. This is so because the principal becomes better informed ex post about agent types, via the realization of common uncertainty, and can effectively penalize or reward the agents ex post. Thus, unlike the standard adverse selection problem without common uncertainty where the principal always benefits from ex ante screening, it is shown that ex post sorting through relative performance evaluation reduces the scope for ex ante screening through menus, and can eliminate it completely if agents are known to not be very heterogeneous. This is consistent with observed practice in industries where the primary compensation mechanism is a cardinal tournament which is uniform among employees. The analysis connotes that by using relative instead of absolute performance measures, firms with employees who are not substantially heterogeneous not only can alleviate the agency problem, but there is also no need to extract the agents' ex ante private information about their innate abilities via a screening menu.

Keywords: Tournaments, Contests

JEL Classification: D82, D86

Suggested Citation

Tsoulouhas, Theofanis, Do Tournaments Solve the Adverse Selection Problem? (December 22, 2016). Forthcoming in the Journal of Economics and Management Strategy. Available at SSRN: https://ssrn.com/abstract=2902347

Theofanis Tsoulouhas (Contact Author)

University of California-Merced, School of Social Sciences, Humanities & Arts, The Ernest & Julio Gallo Management Program ( email )

Merced, CA 95343
United States
209-228-4640 (Phone)

HOME PAGE: http://tsoulouhas.info

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